Coal Stocks Are Back

by Aaron Levitt | July 24, 2013 9:40 am

The coal sector has been in a constant ebb and flow during the past few years — with most of the flow going right down the proverbial toilet.

The combination of increased environmental regulation and rock-bottom natural gas prices took the wind out of coal’s sails. It’s been downhill ever since for the sector as mine closures, falling share prices and even bankruptcies[1] have become the norm.

Coal stocks looked doomed … until natural gas prices began to rise at the beginning of the spring.

A peculiar thing has happened since natural gas prices recovered: Utilities are once again shifting back to using coal in the face of these rising prices. Add in new cost controls, idled expansion plans, rising exports and even a surprise profit or two, and you have to wonder if King Coal is regaining his throne.

The Canary in the Coal Mine Is Still Kickin’

Despite showing a year-over-year decrease in earnings, analysts and investors were singing the praises[2] of mega-coal producer Peabody’s (BTU[3]) latest earnings release. The reason? The miner reported a surprise 33 cent per share profit after earlier estimates showed that BTU would actually lose 5 cents. The company’s GAAP earnings — which include an income tax gain of 14 cents and asset impairment charge of 8 cents – were 39 cents per share.

That should come as a pretty big shock to anyone who has followed the coal sector during the past year or so. Like many other coal companies, Peabody struggled amid stubbornly soft demand as utilities turned to cheaper natural gas to generate electricity. Meanwhile, slowing global growth — especially in commodity-hungry China — hurt demand for metallurgical coal (or steelmaking coal) as well. As a result, coal prices were driven down, hurting margins at a variety of producers.

So the fact that Peabody was able to pull together a profit of any kind was impressive and could bode well for other larger producers following similar cost reduction strategies. Perhaps most impressive was the miner’s bullish outlook for the coal.

Inventories of the fuel have finally begun to shrink as many E&P firms have switched towards more lucrative liquids production[4]. That’s causing natural gas prices to creep up, and with the summer heat baking much of the country, prices for the fuel are just near the $4 per million Btus mark. At the same time, far-dated futures contracts are hovering closer to the $5 price.

Given those higher prices — natural gas was sitting below $2 pretty recently — there are now more incentives for utility companies to switch back to coal for their generation needs. That shift seems to be happening sooner than many analysts predicted.

Coal demand increased 11% in the first half of the year and accounted for approximately 40% of total electricity generation. In comparison, natural gas saw a 15% decline in its generation. Peabody expects that trend to continue as coal consumption for electricity generation will grow by 50 to 70 million tons over prior-year levels as the fuel has regained significant market share from natural gas. At the same time, China’s coal imports of both metallurgical and thermal coal rose 13% through June, while India saw a huge a 42% increase in thermal coal imports.

This rising demand — combined with the circumstances that curtailed production — is keeping coal inventories at their lowest levels in years and painting a much brighter picture for the coal industry.

A Sector-Wide Recovery?

With production in key regions like the Powder River Basin and Australia, Peabody represents the global leader in the coal sector. The fact that it is both an export and domestic specialist for all varieties of coal still makes it the top investment in the space.

If anybody was going to beat earnings expectations, it was going to be Peabody.

However, rising coal demand and prices could do wonders for the other sector players this earnings season. While I’m not expecting miracles form James River (JRCC[5]) or Walter Energy (WLT[6]) — they all have funding issues[7] to worry about — the case for both Alpha Natural Resources (ANR[8]) and Arch Coal (ACI[9]) to beat is also strong.

Both firms represent beaten-down plays that — like BTU — have undergone cost-cutting measures and canceled expansion plans. Any rising metallurgical coal demand from China — as evident from Peabody’s narrative[10] — should help boost Alpha’s earnings report as the firm is the third-largest miner in the world of coking coal. At the same time, rising gas-to-coal switching will underscore Arch’s profits as it’s the leading thermal coal play for electricity generation in the U.S.

Both stocks are down roughly 90% since February of 2011 and are expected to produce losses this quarter. However, any earnings surprise could send the shares skyward and help reinforce the idea that King Coal is getting his crown back.

For investors, that could be the signal to finally buy the beleaguered and beaten-down coal names.

As of this writing, Aaron Levitt did not hold a position in any of the aforementioned securities.

  1. even bankruptcies:
  2. singing the praises:
  3. BTU:
  4. lucrative liquids production:
  5. JRCC:
  6. WLT:
  7. funding issues:
  8. ANR:
  9. ACI:
  10. Peabody’s narrative:

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